Reflections
May 2011 Issue 131
Reflections®
About this Newsletter Reflections is a monthly publication written by John Gilbert, CIO, GR–NEAM. Each issue focuses on current capital markets and investment topics. Our clients find it somewhat unique from many investment publications typically received.
For More Information For more information please contact one of our Marketing professionals: Marie Callahan [email protected] Mike Gilotti [email protected]
General Re–New England Asset Management, Inc.® Pond View Corporate Center 76 Batterson Park Road Farmington, CT 06032 Tel. 860 676 8722 www.grneam.com
The Offside Rule, The Fed, and Inflation In soccer, as it is known in North America, or football, as it is known everywhere else, one is onside if one is abreast of the defender. Farther forward and one is ruled offside (and farther back one may be derided as slow). The Federal Reserve under Chairman Bernanke is careful to remain abreast of the data, and no farther forward. This is in contrast to the European Central Bank (ECB), who believe in more anticipatory behavior. The ECB’s recent rate increase was in part a difference in measurement preference, focusing on inflation including food and energy, and partly philosophical. The risk for the ECB is that they are offside—that oil prices slow economic activity anyway, and the rate increase was untimely. The risk to the Fed is that they are late. Time will tell, but the Fed’s deliquence in remaining abreast of the data may sacrifice foresight. Ben Bernanke’s assessment in 2007 that the effects of a housing contraction in the U.S. were contained, in his words, appeared to us at the time to be more optimistic than likely, and was subsequently proved wrong.
Inflation expectations are already accelerating as measured by breakeven bond yields. The Fed majority holds that the current flare in commodity prices is self-limiting, and that concern at rising inflation is misled, although there appears to be an increase in dissent. The Fed’s indicator of inflation is the Personal Consumption Expenditure (PCE) Deflator for technical reasons, focusing on the version that excludes food and energy (the core index). It is true that the core index is more stable and that the more volatile headline number, including food and energy, cycles around the core number. Chart 1. Personal Consumption Expenditure Price Index 6%
Year-to-Year Change
5%
There is no correlation because, as in so many coincident economic outcomes, the relationships are labile and affected by other variables. Table 1 illustrates the previous occasions from the beginning of the data when capacity utilization was at the current level, with the accompanying level of inflation. Table 1. Period
Inflation
Late 1970
4.8%
Early 1975
10.2%
Mid 1980
9.1%
Late 1981
7.9%
Late 1983
4.7%
4%
Early 2001
1.7%
3%
Early 2004
1.8%
2%
Mid 2008
2.6%
1%
Early 2011
0.9%
Median
4.7%
0%
Sources: Federal Reserve and GR–NEAM Analytics
-1%
The measure of slack in the economy that is urgent in the minds of Fed members is unemployment, since that is the other leg of their dual mandate. That is a political and not economic observation for purposes of Fed policy. Unemployment lags inflation because of the Fed’s own responses to inflation, as shown in Chart 3.
-2% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 PCE PCE Core (excluding Food and Energy) Sources: Bureau of Economic Analysis (BEA) and GR–NEAM Analytics
The current core reading is pretty much moribund and is the stated reason the Fed is doing nothing. The current orthodoxy at the Fed is that there is so much slack in the economy that there is no imminent inflation. Capacity utilization is low, the thinking goes, and producers will compete by holding prices down. There is little question that cyclical changes in capacity utilization affect inflation. But over time there is no reliable connection between capacity utilization and inflation, as shown in Chart 2.
Chart 3. Inflation and Unemployment 12% 10% 8% 6%
Chart 2. Inflation and Capacity Utilization
10%
Falling Capacity Utilization, Rising Inflation Rising Capacity Utilization, Falling Inflation
Inflation
8%
2% 87%
82%
6% 4%
77%
2%
72%
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007
67%
PCE Core
Capacity Utilization (right scale)
Sources: BEA, Federal Reserve and GR–NEAM Analytics
2
4% 92% Capacity Utilization
12%
GR–NEAM
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007 PCE Core
Unemployment
Sources: BEA, Bureau of Labor Statistics and GR–NEAM Analytics
Economic orthodoxies have a shelf life. Money supply growth ruled for a while, and won Milton Friedman a Nobel Prize. But that apparent certainty vaporized as conditions changed (Chart 4).
12%
Money Supply Accelerating, Inflation Rising
Money Decelerating, Inflation Falling
16% 14% 12%
10%
Chinese currency pegged to dollar
8% 6%
2%
2%
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007
0%
Money Supply (right scale)
Sources: BEA, Federal Reserve and GR–NEAM Analytics
The response of inflation to growth in the money supply disappeared in the 1990s. Our view is that the most important number in the world is, and has been for years now, the exchange value of the Chinese yuan. The Chinese currency is pegged to the dollar at a level below a market exchange rate. That fixing of the rate is what makes it so important, since the distortions that result are not measurable but almost certainly material. This peculiar and eventually disruptive policy is shown in Chart 5. Chart 5. Chinese Yuan Suppressed U.S. Import Inflation
Chinese Yuan in $ U.S.
3.0%
8%
2.5%
6%
8%
4%
PCE Core
Chart 6. Inflation and Import Prices
10%
6%
4%
Prices respond to changes at the margin. U.S. inflation is affected by changes in import prices, since those affect the marginal pricing of tradable goods as shown in Chart 6.
PCE Inflation
14%
0% 1.0%
PCE Core
We only have detailed data on import prices for recent periods, but they show the effect of Chinese prices on imports in general in Chart 7. Chart 7. Chinese Import Prices and Inflation 8% 6%
China was exporting deflation
-2% -4%
0.14
-6% 2004
Sources: Bloomberg L.P. and GR–NEAM Analytics
The fixing of the yuan at an undervalued level underpriced a massive labor supply by fiat. Like every government intervention in economics that has caused multiple distortions. In general it has had the effect of suppressing measured inflation, particularly in the U.S., and with rising labor costs in China and revaluation of the yuan that period is coming to an end.
Not anymore
0%
0.16
0.10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Import Prices Excluding Fuels (right scale)
Sources: BEA, Bureau of Labor Statistics, and GR–NEAM Analytics
2%
0.12
-4%
0.0% -6% 2002 2004 2005 2006 2007 2008 2009 2010 2011
0.22
0.18
-2%
0.5%
0.24
Chinese currency pegged at fixed levels 1995–2005 and late 2008 to early 2010
2%
1.5%
4%
0.20
4%
2.0%
Import Price Change
Chart 4. Inflation and Money Supply Growth
2006 2007 Chinese Import Prices
2008 2009 2010 2011 All Import Prices Excluding Fuels
Sources: Bureau of Labor Statistics and GR–NEAM Analytics
The implications for investors are large. We are likely ending the multi-decade decline in inflation which has been in part a result of distortions that have sown the seeds of their own reversal. From 2005 to 2008 the Chinese currency was finally allowed to appreciate, with inflationary effects upon U.S. import prices and a flow through to prices in general. That was suppressed for a while when the yuan was pegged again in the financial crisis. It is now rising again, with upward price pressure the likely outcome. The results can be anticipated from Chart 8.
Reflections, May 2011
3
Chart 8. Chinese Import Prices and Inflation 8% 6%
12% Yuan rising at double Fed’s inflation limit of 2%
10%
4%
8%
2%
6%
0%
4%
-2%
2%
-4%
0%
-6% 2004
-2% 2006 2007 2008 2009 2010 2011 Chinese Import Prices (left) Chinese Yuan (right) All Imports Excluding Fuels (left)
Sources: Bureau of Labor Statistics, Bloomberg L.P. and GR–NEAM Analytics
The coming increase in inflation will likely find its way into the Fed’s language in coming months. Their job will become much harder as they are no longer free to focus entirely upon the full employment leg of their dual mandate, but must deal with the coming secular rise in inflationary forces. That will be even as the contractionary effect of the housing market and deleveraging of the household and financial sectors in the U.S. persist. The danger to investors at the moment is that their risks are not symmetrical with those of the Fed. If the Fed is abreast of the data, they do what they can to immunize themselves against attacks from Congress or the Administration. But investing money over time must be anticipatory if it is to be successful. Simply remaining onside the obvious data exposes one to error, especially now. Financial assets are pricing inflation estimates that are too low.
© 2011 General Re–New England Asset Management, Inc. This report has been prepared from original sources and data we believe to be reliable, but we make no representations as to its accuracy, timeliness or completeness. This report is published solely for information purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy any security. Please consult with your investment professionals, tax advisors or legal counsel as necessary before relying on this material. This is an analytical piece and references to any specific securities are not to be construed as an investment recommendation. From time to time, one or more of GR–NEAM’s clients, and/or the author, may personally hold positions in any of the securities referenced in this piece. REF201105-131
Reflections®
About this Newsletter Reflections is a monthly publication written by John Gilbert, CIO, GR–NEAM. Each issue focuses on current capital markets and investment topics. Our clients find it somewhat unique from many investment publications typically received.
For More Information For more information please contact one of our Marketing professionals: Marie Callahan [email protected] Mike Gilotti [email protected]
General Re–New England Asset Management, Inc.® Pond View Corporate Center 76 Batterson Park Road Farmington, CT 06032 Tel. 860 676 8722 www.grneam.com
The Offside Rule, The Fed, and Inflation In soccer, as it is known in North America, or football, as it is known everywhere else, one is onside if one is abreast of the defender. Farther forward and one is ruled offside (and farther back one may be derided as slow). The Federal Reserve under Chairman Bernanke is careful to remain abreast of the data, and no farther forward. This is in contrast to the European Central Bank (ECB), who believe in more anticipatory behavior. The ECB’s recent rate increase was in part a difference in measurement preference, focusing on inflation including food and energy, and partly philosophical. The risk for the ECB is that they are offside—that oil prices slow economic activity anyway, and the rate increase was untimely. The risk to the Fed is that they are late. Time will tell, but the Fed’s deliquence in remaining abreast of the data may sacrifice foresight. Ben Bernanke’s assessment in 2007 that the effects of a housing contraction in the U.S. were contained, in his words, appeared to us at the time to be more optimistic than likely, and was subsequently proved wrong.
Inflation expectations are already accelerating as measured by breakeven bond yields. The Fed majority holds that the current flare in commodity prices is self-limiting, and that concern at rising inflation is misled, although there appears to be an increase in dissent. The Fed’s indicator of inflation is the Personal Consumption Expenditure (PCE) Deflator for technical reasons, focusing on the version that excludes food and energy (the core index). It is true that the core index is more stable and that the more volatile headline number, including food and energy, cycles around the core number. Chart 1. Personal Consumption Expenditure Price Index 6%
Year-to-Year Change
5%
There is no correlation because, as in so many coincident economic outcomes, the relationships are labile and affected by other variables. Table 1 illustrates the previous occasions from the beginning of the data when capacity utilization was at the current level, with the accompanying level of inflation. Table 1. Period
Inflation
Late 1970
4.8%
Early 1975
10.2%
Mid 1980
9.1%
Late 1981
7.9%
Late 1983
4.7%
4%
Early 2001
1.7%
3%
Early 2004
1.8%
2%
Mid 2008
2.6%
1%
Early 2011
0.9%
Median
4.7%
0%
Sources: Federal Reserve and GR–NEAM Analytics
-1%
The measure of slack in the economy that is urgent in the minds of Fed members is unemployment, since that is the other leg of their dual mandate. That is a political and not economic observation for purposes of Fed policy. Unemployment lags inflation because of the Fed’s own responses to inflation, as shown in Chart 3.
-2% 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 PCE PCE Core (excluding Food and Energy) Sources: Bureau of Economic Analysis (BEA) and GR–NEAM Analytics
The current core reading is pretty much moribund and is the stated reason the Fed is doing nothing. The current orthodoxy at the Fed is that there is so much slack in the economy that there is no imminent inflation. Capacity utilization is low, the thinking goes, and producers will compete by holding prices down. There is little question that cyclical changes in capacity utilization affect inflation. But over time there is no reliable connection between capacity utilization and inflation, as shown in Chart 2.
Chart 3. Inflation and Unemployment 12% 10% 8% 6%
Chart 2. Inflation and Capacity Utilization
10%
Falling Capacity Utilization, Rising Inflation Rising Capacity Utilization, Falling Inflation
Inflation
8%
2% 87%
82%
6% 4%
77%
2%
72%
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007
67%
PCE Core
Capacity Utilization (right scale)
Sources: BEA, Federal Reserve and GR–NEAM Analytics
2
4% 92% Capacity Utilization
12%
GR–NEAM
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007 PCE Core
Unemployment
Sources: BEA, Bureau of Labor Statistics and GR–NEAM Analytics
Economic orthodoxies have a shelf life. Money supply growth ruled for a while, and won Milton Friedman a Nobel Prize. But that apparent certainty vaporized as conditions changed (Chart 4).
12%
Money Supply Accelerating, Inflation Rising
Money Decelerating, Inflation Falling
16% 14% 12%
10%
Chinese currency pegged to dollar
8% 6%
2%
2%
0% 1967 1972 1977 1982 1987 1992 1997 2002 2007
0%
Money Supply (right scale)
Sources: BEA, Federal Reserve and GR–NEAM Analytics
The response of inflation to growth in the money supply disappeared in the 1990s. Our view is that the most important number in the world is, and has been for years now, the exchange value of the Chinese yuan. The Chinese currency is pegged to the dollar at a level below a market exchange rate. That fixing of the rate is what makes it so important, since the distortions that result are not measurable but almost certainly material. This peculiar and eventually disruptive policy is shown in Chart 5. Chart 5. Chinese Yuan Suppressed U.S. Import Inflation
Chinese Yuan in $ U.S.
3.0%
8%
2.5%
6%
8%
4%
PCE Core
Chart 6. Inflation and Import Prices
10%
6%
4%
Prices respond to changes at the margin. U.S. inflation is affected by changes in import prices, since those affect the marginal pricing of tradable goods as shown in Chart 6.
PCE Inflation
14%
0% 1.0%
PCE Core
We only have detailed data on import prices for recent periods, but they show the effect of Chinese prices on imports in general in Chart 7. Chart 7. Chinese Import Prices and Inflation 8% 6%
China was exporting deflation
-2% -4%
0.14
-6% 2004
Sources: Bloomberg L.P. and GR–NEAM Analytics
The fixing of the yuan at an undervalued level underpriced a massive labor supply by fiat. Like every government intervention in economics that has caused multiple distortions. In general it has had the effect of suppressing measured inflation, particularly in the U.S., and with rising labor costs in China and revaluation of the yuan that period is coming to an end.
Not anymore
0%
0.16
0.10 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
Import Prices Excluding Fuels (right scale)
Sources: BEA, Bureau of Labor Statistics, and GR–NEAM Analytics
2%
0.12
-4%
0.0% -6% 2002 2004 2005 2006 2007 2008 2009 2010 2011
0.22
0.18
-2%
0.5%
0.24
Chinese currency pegged at fixed levels 1995–2005 and late 2008 to early 2010
2%
1.5%
4%
0.20
4%
2.0%
Import Price Change
Chart 4. Inflation and Money Supply Growth
2006 2007 Chinese Import Prices
2008 2009 2010 2011 All Import Prices Excluding Fuels
Sources: Bureau of Labor Statistics and GR–NEAM Analytics
The implications for investors are large. We are likely ending the multi-decade decline in inflation which has been in part a result of distortions that have sown the seeds of their own reversal. From 2005 to 2008 the Chinese currency was finally allowed to appreciate, with inflationary effects upon U.S. import prices and a flow through to prices in general. That was suppressed for a while when the yuan was pegged again in the financial crisis. It is now rising again, with upward price pressure the likely outcome. The results can be anticipated from Chart 8.
Reflections, May 2011
3
Chart 8. Chinese Import Prices and Inflation 8% 6%
12% Yuan rising at double Fed’s inflation limit of 2%
10%
4%
8%
2%
6%
0%
4%
-2%
2%
-4%
0%
-6% 2004
-2% 2006 2007 2008 2009 2010 2011 Chinese Import Prices (left) Chinese Yuan (right) All Imports Excluding Fuels (left)
Sources: Bureau of Labor Statistics, Bloomberg L.P. and GR–NEAM Analytics
The coming increase in inflation will likely find its way into the Fed’s language in coming months. Their job will become much harder as they are no longer free to focus entirely upon the full employment leg of their dual mandate, but must deal with the coming secular rise in inflationary forces. That will be even as the contractionary effect of the housing market and deleveraging of the household and financial sectors in the U.S. persist. The danger to investors at the moment is that their risks are not symmetrical with those of the Fed. If the Fed is abreast of the data, they do what they can to immunize themselves against attacks from Congress or the Administration. But investing money over time must be anticipatory if it is to be successful. Simply remaining onside the obvious data exposes one to error, especially now. Financial assets are pricing inflation estimates that are too low.
© 2011 General Re–New England Asset Management, Inc. This report has been prepared from original sources and data we believe to be reliable, but we make no representations as to its accuracy, timeliness or completeness. This report is published solely for information purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy any security. Please consult with your investment professionals, tax advisors or legal counsel as necessary before relying on this material. This is an analytical piece and references to any specific securities are not to be construed as an investment recommendation. From time to time, one or more of GR–NEAM’s clients, and/or the author, may personally hold positions in any of the securities referenced in this piece. REF201105-131
